How to Succeed in Tax Rankings Without Really Trying

The conservative Tax Foundation just released the 2017 version of its State Business Tax Climate Index (SBTCI) and once again, Minnesota is purportedly in terrible shape. Minnesota policymakers need only follow a simple strategy to improve its ranking on the SBTCI: increase the regressivity of Minnesota’s state and local tax system by shifting a larger share of state and local taxes away from high income households and on to those with the least ability to pay.

“Taxes matter to business” is a mantra repeated throughout the 2017 SBTCI. More specifically, the SBTCI argues that states with low tax costs will be more attractive to businesses and more likely to enjoy economic growth. This assertion does not reflect the full reality of the relationship between taxation and business climate, insofar as businesses that pay higher taxes might perform better and be more profitable than businesses with low taxes, provided that the higher taxes are contributing toward a better educated and more skilled workforce, a superior transportation system, safer and more livable communities, and other public amenities that businesses need to prosper.

Even if we accept the overly simplistic formulation that low business tax costs equals greater economic growth, the SBTCI has a serious flaw in that it does not actually measure what businesses pay in taxes. In 2013, economist Peter Fisher noted—using data from a previous SBTCI—that “there is really no relationship at all” between the SBTCI score and the total effective business tax rate (i.e., total state and local business taxes within a state as a percent of state GDP). Thus, despite the Tax Foundation’s insistence that taxes matter to business, the SBTCI fails as a measure of what businesses actually pay in taxes from state to state.

North Star has repeated Fisher’s 2013 analysis using scores from the new 2017 SBTCI and the most recent state business effective tax rates calculated by the Council on State Taxation (COST) and published by Ernst & Young (summarized in a May 2016 North Star article). This analysis revealed that there was a weak positive correlation (R = 0.144) between the 2017 SBTCI scores and the most recent business effective tax rates. In other words, there was a slight tendency for states that did well on the 2017 SBTCI to have higher business tax rates than states that did poorly, although the relationship was not statistically significant.

[Addendum, 10/27/16: Since the publication of this analysis, Peter Fisher has conducted a similar analysis of the relationship between 2017 SBTCI scores and the most recent state business effective tax rates from COST, except that he excludes severance taxes from the calculation of the effective tax rate on the grounds that the final incidence of these taxes generally falls on consumers, not businesses. After excluding severance taxes, Fisher finds no statistically significant correlation between 2017 SBTCI scores and state business effective tax rates. Fisher concludes that “There is little correlation between the SBTCI ranking and what businesses actually pay in state taxes.”]

Additional analysis shows that states that do well on the under the SBTCI also tend to have higher business taxes per employee and higher business taxes as a percentage of all state and local taxes paid within the state.* While the first of these relationships is slight (R = 0.215), the second (R = 0.538) is statistically significant at the 0.01 level. Minnesota gets no credit in the SBTCI for being below the national average on both of these measures.†

How is it that a report that asserts that “taxes matter to business” has resulted in an index that tends to assigns superior scores to states with relatively high business taxes? Fisher provides the answer:

[The SBTCI] ignores the consensus approach to assessing business taxes in the economic literature and attempts to portray the effect of state and local tax law on business profits in an entirely different fashion: by stirring together no less than 118 features of the tax law and producing out of that stew a single, arbitrary index number. That number turns out to bear very little relationship to what businesses actually pay.

What explains the Tax Foundation’s usage of this convoluted methodology to calculate the SBTCI? According to Fisher,

…the [Tax Foundation] sticks with its system because it enables the Foundation to heavily penalize states with more progressive tax systems above all, while concealing this objective in an arbitrary system of scaled and weighted numbers.

On the one hand, the SBTCI rewards states that have no income or estate tax or that impose such taxes at very low rates. On the other hand, states like Minnesota, that rely relatively more on progressive income and estate taxes, are penalized.

An analysis of the relationship between the SBTCI scores and tax regressivity/progressivity in the fifty states lends support to Fisher’s conclusion. North Star analysis of the relationship between state and local tax regressivity in each of the fifty states (based on indexes originally published in a 2015 Growth & Justice report and later reprinted in the 2015 Minnesota Tax Incidence Study) and the SBTCI scores found that states that did best on the SBTCI tend to have the most regressive state and local tax systems. This powerful relationship (R = 0.618) was statistically significant at the 0.01 level. In short, states that score highly on the SBTCI tend to shift taxes away from high-income households and on to low- and moderate-income households much more so than do states that do poorly on the SBTCI.

The chart below illustrates this relationship. States that spread a disproportionate share of state and local taxes on low- and moderate-income households while sheltering high-income households are rewarded with the best ranks from the SBTCI. For example, four of the five states with the highest ranks on the SBTCI have state and local tax systems that are among the five most regressive in the nation. The fifth state—Alaska—has a tax system that is more regressive than in all but ten states.

Meanwhile, the five states that do worst under the SBTCI each rank among the ten least regressive states in the nation. For example, Minnesota, which ranks 46th on the SBTCI (5th worst in the nation), has the seventh least regressive state and local tax system in the nation. Despite its strong performance relative to other states in terms of reducing tax regressivity, Minnesota’s state and local tax system is still modestly regressive according to information from both the 2015 Minnesota Tax Incidence Study and the 2015 Growth & Justice tax regressivity report.

The moral of the story is that to do well under the SBTCI, a state needs to adopt policies that shift a disproportionate share of state and local taxes on to those households with the least ability to pay, while imposing relatively lower taxes on those with the greatest ability to pay. Of course, such a strategy runs the risk of further eroding the purchasing power of lower- and middle-income families, thereby reducing demand for goods and services, which would lead to less employment and less economic growth over the long term. Such is the price of success in the business tax climate game, at least under the rules established by the Tax Foundation in the SBTCI.

*These correlations are based on business taxes per employee and business taxes as a percentage of total state and local taxes as calculated by COST and published by Ernst & Young.

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North Star Policy Institute is a progressive think tank that advances awareness and discussion about state-level public policies. We produce original research, articles, reports, and commentaries that center the priorities of Minnesota’s working people and families.